Industrial Organisation Off and On the Internet

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Industrial Organisation Off and On the Internet

  1. 1. Industrial Organisation Off and On the Internet Some Lessons From the Past Greg Taylor Oxford Internet Institute University of Oxford
  2. 2. Economics The study of constrained choice.
  3. 3. Economics The study of constrained choice. Build mathematical models of decision makers’ behaviours.
  4. 4. Economics The study of constrained choice. Build mathematical models of decision makers’ behaviours. Typically gives us very sharp conclusions.
  5. 5. Economics The study of constrained choice. Build mathematical models of decision makers’ behaviours. Typically gives us very sharp conclusions. Suggests effects of policy changes—comparative statics.
  6. 6. Economics The study of constrained choice. Build mathematical models of decision makers’ behaviours. Typically gives us very sharp conclusions. Suggests effects of policy changes—comparative statics. But hard: the world is very complex, so we need assumptions.
  7. 7. Economics The study of constrained choice. Build mathematical models of decision makers’ behaviours. Typically gives us very sharp conclusions. Suggests effects of policy changes—comparative statics. But hard: the world is very complex, so we need assumptions. Thus another advantage of the mathematical approach: encourages transparency of assumptions.
  8. 8. Economics The study of constrained choice. Build mathematical models of decision makers’ behaviours. Typically gives us very sharp conclusions. Suggests effects of policy changes—comparative statics. But hard: the world is very complex, so we need assumptions. Thus another advantage of the mathematical approach: encourages transparency of assumptions. Let’s take a look at a textbook example of how some simple assumptions can be turned into a model.
  9. 9. Outline Price discrimination: from assumptions to policy statements Assumptions and applicability
  10. 10. Price discrimination Price discrimination is the practice of pricing such that different groups of consumers yield different price-cost margins for the firm.
  11. 11. A price discrimination example Imagine a monopolist firm that sells some products of varying quality.
  12. 12. A price discrimination example Imagine a monopolist firm that sells some products of varying quality. Assume that quality can be indexed by a number, q. Let q be continuous. Suppose that it costs C(q) to provide a product with quality q. Let C (q) > 0 (increasing costs), C (q) > 0 (convex costs), and C(0) = 0.
  13. 13. A price discrimination example Imagine a monopolist firm that sells some products of varying quality. Assume that quality can be indexed by a number, q. Let q be continuous. Suppose that it costs C(q) to provide a product with quality q. Let C (q) > 0 (increasing costs), C (q) > 0 (convex costs), and C(0) = 0. There are two types of customer: low (L), and high (H).
  14. 14. A price discrimination example Imagine a monopolist firm that sells some products of varying quality. Assume that quality can be indexed by a number, q. Let q be continuous. Suppose that it costs C(q) to provide a product with quality q. Let C (q) > 0 (increasing costs), C (q) > 0 (convex costs), and C(0) = 0. There are two types of customer: low (L), and high (H). A type i ∈ {L, H} consumer enjoys surplus Ui = θi q − p. where p is the price to be paid to the firm, and θi is the consumer’s willingness to pay for a one unit increase in quality.
  15. 15. A price discrimination example Imagine a monopolist firm that sells some products of varying quality. Assume that quality can be indexed by a number, q. Let q be continuous. Suppose that it costs C(q) to provide a product with quality q. Let C (q) > 0 (increasing costs), C (q) > 0 (convex costs), and C(0) = 0. There are two types of customer: low (L), and high (H). A type i ∈ {L, H} consumer enjoys surplus Ui = θi q − p. where p is the price to be paid to the firm, and θi is the consumer’s willingness to pay for a one unit increase in quality. Let θL < θH .
  16. 16. First order discrimination In a perfect world, the firm would know the type of consumer it is facing. It could then design a product/price combination for each type.
  17. 17. First order discrimination In a perfect world, the firm would know the type of consumer it is facing. It could then design a product/price combination for each type. i.e. Sell a ‘budget’ product with q = qL at price pL to L-type consumers, and a ‘luxury’ product with q = qH at price pH .
  18. 18. First order discrimination In a perfect world, the firm would know the type of consumer it is facing. It could then design a product/price combination for each type. i.e. Sell a ‘budget’ product with q = qL at price pL to L-type consumers, and a ‘luxury’ product with q = qH at price pH . The firm’s objective would then be to max pi − C(qi ) qi ,pi
  19. 19. First order discrimination In a perfect world, the firm would know the type of consumer it is facing. It could then design a product/price combination for each type. i.e. Sell a ‘budget’ product with q = qL at price pL to L-type consumers, and a ‘luxury’ product with q = qH at price pH . The firm’s objective would then be to max pi − C(qi ) qi ,pi subject to the constraint θi qi − pi ≥ 0.
  20. 20. First order discrimination In a perfect world, the firm would know the type of consumer it is facing. It could then design a product/price combination for each type. i.e. Sell a ‘budget’ product with q = qL at price pL to L-type consumers, and a ‘luxury’ product with q = qH at price pH . The firm’s objective would then be to max pi − C(qi ) qi ,pi subject to the constraint θi qi − pi ≥ 0. This kind of behaviour is called first degree price discrimination.
  21. 21. First order discrimination max pi − C(qi ) s.t. θi qi − pi ≥ 0. qi ,pi
  22. 22. First order discrimination max pi − C(qi ) s.t. θi qi − pi ≥ 0. qi ,pi In fact, since the firm knows θi , it can just set pi = θi qi .
  23. 23. First order discrimination max pi − C(qi ) s.t. θi qi − pi ≥ 0. qi ,pi In fact, since the firm knows θi , it can just set pi = θi qi . Substituting this into the maximisation problem gives max θi qi − C(qi ). qi
  24. 24. First order discrimination max pi − C(qi ) s.t. θi qi − pi ≥ 0. qi ,pi In fact, since the firm knows θi , it can just set pi = θi qi . Substituting this into the maximisation problem gives max θi qi − C(qi ). qi Increasing qi by one unit increases revenue by θi , and cost by C (qi ).
  25. 25. First order discrimination max pi − C(qi ) s.t. θi qi − pi ≥ 0. qi ,pi In fact, since the firm knows θi , it can just set pi = θi qi . Substituting this into the maximisation problem gives max θi qi − C(qi ). qi Increasing qi by one unit increases revenue by θi , and cost by C (qi ). It is therefore profitable to increase quality if and only if θi > C (qi ).
  26. 26. First order discrimination max pi − C(qi ) s.t. θi qi − pi ≥ 0. qi ,pi In fact, since the firm knows θi , it can just set pi = θi qi . Substituting this into the maximisation problem gives max θi qi − C(qi ). qi Increasing qi by one unit increases revenue by θi , and cost by C (qi ). It is therefore profitable to increase quality if and only if θi > C (qi ). ∗ So quality qi is produced where θi = C (qi ), i.e. where marginal cost of qi is equal to marginal willingness to pay for it.
  27. 27. What can we say about these qs? Firstly, by giving firms so much information about consumers, we have left the latter with no surplus.
  28. 28. What can we say about these qs? Firstly, by giving firms so much information about consumers, we have left the latter with no surplus. However, that θi = C (qi ) implies the chosen qualities are efficient!
  29. 29. What can we say about these qs? Firstly, by giving firms so much information about consumers, we have left the latter with no surplus. However, that θi = C (qi ) implies the chosen qualities are efficient! Social welfare given by consumer + firm welfare: (θi qi − p) + (p − C(qi ))
  30. 30. What can we say about these qs? Firstly, by giving firms so much information about consumers, we have left the latter with no surplus. However, that θi = C (qi ) implies the chosen qualities are efficient! Social welfare given by consumer + firm welfare: (θi qi − p) + (p − C(qi )) = θi qi − C(qi ). This is exactly what the firm is maximising!
  31. 31. What can we say about these qs? Firstly, by giving firms so much information about consumers, we have left the latter with no surplus. However, that θi = C (qi ) implies the chosen qualities are efficient! Social welfare given by consumer + firm welfare: (θi qi − p) + (p − C(qi )) = θi qi − C(qi ). This is exactly what the firm is maximising! That θi = C (qi ) also implies that qL < qH , and hence pL < pH .
  32. 32. What can we say about these qs? Firstly, by giving firms so much information about consumers, we have left the latter with no surplus. However, that θi = C (qi ) implies the chosen qualities are efficient! Social welfare given by consumer + firm welfare: (θi qi − p) + (p − C(qi )) = θi qi − C(qi ). This is exactly what the firm is maximising! That θi = C (qi ) also implies that qL < qH , and hence pL < pH .
  33. 33. Segmentation breakdown Now, firms typically cannot observe θi and so must depend on the consumer to buy the product designed for them.
  34. 34. Segmentation breakdown Now, firms typically cannot observe θi and so must depend on the consumer to buy the product designed for them. Therein lies a problem: if high consumers buy the high quality product, they get θH qH − pH = θH qH − θH qH = 0,
  35. 35. Segmentation breakdown Now, firms typically cannot observe θi and so must depend on the consumer to buy the product designed for them. Therein lies a problem: if high consumers buy the high quality product, they get θH qH − pH = θH qH − θH qH = 0, whereas if they buy the low quality product, they get θ H qL − p L
  36. 36. Segmentation breakdown Now, firms typically cannot observe θi and so must depend on the consumer to buy the product designed for them. Therein lies a problem: if high consumers buy the high quality product, they get θH qH − pH = θH qH − θH qH = 0, whereas if they buy the low quality product, they get θH qL − pL > θL qL − pL
  37. 37. Segmentation breakdown Now, firms typically cannot observe θi and so must depend on the consumer to buy the product designed for them. Therein lies a problem: if high consumers buy the high quality product, they get θH qH − pH = θH qH − θH qH = 0, whereas if they buy the low quality product, they get θH qL − pL > θL qL − pL = 0.
  38. 38. Segmentation breakdown Now, firms typically cannot observe θi and so must depend on the consumer to buy the product designed for them. Therein lies a problem: if high consumers buy the high quality product, they get θH qH − pH = θH qH − θH qH = 0, whereas if they buy the low quality product, they get θH qL − pL > θL qL − pL = 0. Thus, all consumers will buy the budget product—this is called adverse selection.
  39. 39. Solution: mechanism design Question: What can the firm do about this?
  40. 40. Solution: mechanism design Question: What can the firm do about this? Answer: Change it’s maximisation problem.
  41. 41. Solution: mechanism design Question: What can the firm do about this? Answer: Change it’s maximisation problem. Suppose a consumer is of type L with probability α and of type H with probability (1 − α).
  42. 42. Solution: mechanism design Question: What can the firm do about this? Answer: Change it’s maximisation problem. Suppose a consumer is of type L with probability α and of type H with probability (1 − α). The new problem is then: max α(pL − C(qL )) + (1 − α)(pH − C(qH )) qL ,pL ,qH ,pH
  43. 43. Solution: mechanism design Question: What can the firm do about this? Answer: Change it’s maximisation problem. Suppose a consumer is of type L with probability α and of type H with probability (1 − α). The new problem is then: max α(pL − C(qL )) + (1 − α)(pH − C(qH )) qL ,pL ,qH ,pH subject to the constraint θH qH − pH ≥ θH qL − pL (ICH) θ L qL − p L ≥ θ H qH − p H (ICL) θH qH − pH ≥ 0 (IRH) θL qL − pL ≥ 0 (IRL)
  44. 44. Solution: mechanism design Question: What can the firm do about this? Answer: Change it’s maximisation problem. Suppose a consumer is of type L with probability α and of type H with probability (1 − α). The new problem is then: max α(pL − C(qL )) + (1 − α)(pH − C(qH )) qL ,pL ,qH ,pH subject to the constraint θH qH − pH ≥ θH qL − pL (ICH) θ L qL − p L ≥ θ H qH − p H (ICL) θH qH − pH ≥ 0 (IRH) θL qL − pL ≥ 0 (IRL) Solving such a problem is known as second degree price discrimination.
  45. 45. IRL is ‘binding’ Let’s begin by establishing that IRL holds with equality i.e. that θL qL − pL = 0. This means that home users are left with no surplus.
  46. 46. IRL is ‘binding’ Let’s begin by establishing that IRL holds with equality i.e. that θL qL − pL = 0. This means that home users are left with no surplus. ICH says θ H qH − p H ≥ θ H qL − p L
  47. 47. IRL is ‘binding’ Let’s begin by establishing that IRL holds with equality i.e. that θL qL − pL = 0. This means that home users are left with no surplus. ICH says θ H qH − p H ≥ θ H qL − p L ≥ θ L qL − p L
  48. 48. IRL is ‘binding’ Let’s begin by establishing that IRL holds with equality i.e. that θL qL − pL = 0. This means that home users are left with no surplus. ICH says θ H qH − p H ≥ θ H qL − p L ≥ θ L qL − p L Thus, if θL qL − pL > 0, then it must also be true that θH qH − pH > 0 so that neither IRL nor IRH bind.
  49. 49. IRL is ‘binding’ Let’s begin by establishing that IRL holds with equality i.e. that θL qL − pL = 0. This means that home users are left with no surplus. ICH says θ H qH − p H ≥ θ H qL − p L ≥ θ L qL − p L Thus, if θL qL − pL > 0, then it must also be true that θH qH − pH > 0 so that neither IRL nor IRH bind. But then the firm could increase both pL and pH without violating any condition.
  50. 50. IRL is ‘binding’ Let’s begin by establishing that IRL holds with equality i.e. that θL qL − pL = 0. This means that home users are left with no surplus. ICH says θ H qH − p H ≥ θ H qL − p L ≥ θ L qL − p L Thus, if θL qL − pL > 0, then it must also be true that θH qH − pH > 0 so that neither IRL nor IRH bind. But then the firm could increase both pL and pH without violating any condition. This implies that IRL must bind at the optimum.
  51. 51. ICH is ‘binding’ We next show that ICH holds with equality i.e. that θ H qH − p H = θ H qL − p L . This means if the deal for the luxury product got any worse then H type consumers would switch to buying the budget product.
  52. 52. ICH is ‘binding’ We next show that ICH holds with equality i.e. that θ H qH − p H = θ H qL − p L . This means if the deal for the luxury product got any worse then H type consumers would switch to buying the budget product. Suppose that this weren’t true: θH qH − pH > θH qL − pL
  53. 53. ICH is ‘binding’ We next show that ICH holds with equality i.e. that θ H qH − p H = θ H qL − p L . This means if the deal for the luxury product got any worse then H type consumers would switch to buying the budget product. Suppose that this weren’t true: θH qH − pH > θH qL − pL ≥ θL qL − pL
  54. 54. ICH is ‘binding’ We next show that ICH holds with equality i.e. that θ H qH − p H = θ H qL − p L . This means if the deal for the luxury product got any worse then H type consumers would switch to buying the budget product. Suppose that this weren’t true: θH qH − pH > θH qL − pL ≥ θL qL − pL = 0
  55. 55. ICH is ‘binding’ We next show that ICH holds with equality i.e. that θ H qH − p H = θ H qL − p L . This means if the deal for the luxury product got any worse then H type consumers would switch to buying the budget product. Suppose that this weren’t true: θH qH − pH > θH qL − pL ≥ θL qL − pL = 0 Thus, if ICH does not bind then neither does IRH.
  56. 56. ICH is ‘binding’ We next show that ICH holds with equality i.e. that θ H qH − p H = θ H qL − p L . This means if the deal for the luxury product got any worse then H type consumers would switch to buying the budget product. Suppose that this weren’t true: θH qH − pH > θH qL − pL ≥ θL qL − pL = 0 Thus, if ICH does not bind then neither does IRH. But then the firm could increase pH without violating any condition.
  57. 57. ICH is ‘binding’ We next show that ICH holds with equality i.e. that θ H qH − p H = θ H qL − p L . This means if the deal for the luxury product got any worse then H type consumers would switch to buying the budget product. Suppose that this weren’t true: θH qH − pH > θH qL − pL ≥ θL qL − pL = 0 Thus, if ICH does not bind then neither does IRH. But then the firm could increase pH without violating any condition. This implies that ICH must bind at the optimum.
  58. 58. Can neglect IRH and ICL That ICH binds implies θH qH − pH = θH qL − pL .
  59. 59. Can neglect IRH and ICL That ICH binds implies θH qH − pH = θH qL − pL . IRL implies θL qL − pL = 0.
  60. 60. Can neglect IRH and ICL That ICH binds implies θH qH − pH = θH qL − pL . IRL implies θL qL − pL = 0. Thus we have θH qH − pH = θH qL − pH > θL qL − pL = 0.
  61. 61. Can neglect IRH and ICL That ICH binds implies θH qH − pH = θH qL − pL . IRL implies θL qL − pL = 0. Thus we have θH qH − pH = θH qL − pH > θL qL − pL = 0. So IRH can be neglected.
  62. 62. Can neglect IRH and ICL That ICH binds implies θH qH − pH = θH qL − pL . IRL implies θL qL − pL = 0. Thus we have θH qH − pH = θH qL − pH > θL qL − pL = 0. So IRH can be neglected. This means that business customers get strictly positive utility.
  63. 63. Can neglect ICL It can also be shown that ICL does not bind. Briefly: since ICH binds θH (qH − qL ) = pH − pL .
  64. 64. Can neglect ICL It can also be shown that ICL does not bind. Briefly: since ICH binds θH (qH − qL ) = pH − pL . But ICL says (after rearranging) θL (qH − qL ) ≤ pH − pL .
  65. 65. Can neglect ICL It can also be shown that ICL does not bind. Briefly: since ICH binds θH (qH − qL ) = pH − pL . But ICL says (after rearranging) θL (qH − qL ) ≤ pH − pL . The inequality must be strict since θH > θL .
  66. 66. Can neglect ICL It can also be shown that ICL does not bind. Briefly: since ICH binds θH (qH − qL ) = pH − pL . But ICL says (after rearranging) θL (qH − qL ) ≤ pH − pL . The inequality must be strict since θH > θL . This means that the home bundle is strictly more attractive to home users than is the business edition.
  67. 67. qH is the set at the efficient level ∗ Now we will show that the chosen qH is qH —i.e. where C (qH ) = θH just like in the first order discrimination case. This implies that the quality offered to B-types is socially optimal.
  68. 68. qH is the set at the efficient level ∗ Now we will show that the chosen qH is qH —i.e. where C (qH ) = θH just like in the first order discrimination case. This implies that the quality offered to B-types is socially optimal. Suppose that the optimal qH has C (qH ) < θH .
  69. 69. qH is the set at the efficient level ∗ Now we will show that the chosen qH is qH —i.e. where C (qH ) = θH just like in the first order discrimination case. This implies that the quality offered to B-types is socially optimal. Suppose that the optimal qH has C (qH ) < θH . The firm could change qH to qH + ∆, and increase pH to pH + ∆θH without violating ICH, IRH, or ICL.
  70. 70. qH is the set at the efficient level ∗ Now we will show that the chosen qH is qH —i.e. where C (qH ) = θH just like in the first order discrimination case. This implies that the quality offered to B-types is socially optimal. Suppose that the optimal qH has C (qH ) < θH . The firm could change qH to qH + ∆, and increase pH to pH + ∆θH without violating ICH, IRH, or ICL. When ∆ is small, the change in the firm’s profits is approximately (1 − α)∆(θH − C (qH )) > 0.
  71. 71. qH is the set at the efficient level ∗ Now we will show that the chosen qH is qH —i.e. where C (qH ) = θH just like in the first order discrimination case. This implies that the quality offered to B-types is socially optimal. Suppose that the optimal qH has C (qH ) < θH . The firm could change qH to qH + ∆, and increase pH to pH + ∆θH without violating ICH, IRH, or ICL. When ∆ is small, the change in the firm’s profits is approximately (1 − α)∆(θH − C (qH )) > 0. Thus, original qH was not optimal.
  72. 72. qH is the set at the efficient level ∗ Now we will show that the chosen qH is qH —i.e. where C (qH ) = θH just like in the first order discrimination case. This implies that the quality offered to B-types is socially optimal. Suppose that the optimal qH has C (qH ) < θH . The firm could change qH to qH + ∆, and increase pH to pH + ∆θH without violating ICH, IRH, or ICL. When ∆ is small, the change in the firm’s profits is approximately (1 − α)∆(θH − C (qH )) > 0. Thus, original qH was not optimal. Similarly, if C (qH ) > θH : The firm can reduce qH to qH − ∆, provided it cuts its price for H by at least ∆θH .
  73. 73. qH is the set at the efficient level ∗ Now we will show that the chosen qH is qH —i.e. where C (qH ) = θH just like in the first order discrimination case. This implies that the quality offered to B-types is socially optimal. Suppose that the optimal qH has C (qH ) < θH . The firm could change qH to qH + ∆, and increase pH to pH + ∆θH without violating ICH, IRH, or ICL. When ∆ is small, the change in the firm’s profits is approximately (1 − α)∆(θH − C (qH )) > 0. Thus, original qH was not optimal. Similarly, if C (qH ) > θH : The firm can reduce qH to qH − ∆, provided it cuts its price for H by at least ∆θH . When ∆ is small, the change in the firm’s profits is approximately ∆(C (qH ) − θH ) > 0
  74. 74. Optimal prices Now we can set about characterising the optimal prices.
  75. 75. Optimal prices Now we can set about characterising the optimal prices. Since IRL binds, we know that pL = θL qL .
  76. 76. Optimal prices Now we can set about characterising the optimal prices. Since IRL binds, we know that pL = θL qL . Since ICH binds, we know that θH qH − pH = θH qL − pL , or ∗ equivalently, that pH = pL + θH (qH − qL ).
  77. 77. Optimal prices Now we can set about characterising the optimal prices. Since IRL binds, we know that pL = θL qL . Since ICH binds, we know that θH qH − pH = θH qL − pL , or ∗ equivalently, that pH = pL + θH (qH − qL ). ∗ Combining these two statements: pH = θL qL + θH (qH − qL ).
  78. 78. Firm’s objective The firm’s objective is max α(pL − C(qL )) + (1 − α)(pH − C(qH )). qL ,pL ,qH ,pH
  79. 79. Firm’s objective The firm’s objective is max α(pL − C(qL )) + (1 − α)(pH − C(qH )). qL ,pL ,qH ,pH Substituting in the material we just derived (Note: since ∗ qH = qH , we only need to worry about the choice of qL .): ∗ ∗ max α(θL qL −C(qL ))+(1−α) [θL qL + θH (qH − qL ) − C(qH )] . qL
  80. 80. Firm’s objective The firm’s objective is max α(pL − C(qL )) + (1 − α)(pH − C(qH )). qL ,pL ,qH ,pH Substituting in the material we just derived (Note: since ∗ qH = qH , we only need to worry about the choice of qL .): ∗ ∗ max α(θL qL −C(qL ))+(1−α) [θL qL + θH (qH − qL ) − C(qH )] . qL We can easily calculate the qL that maximises this by differentiating: α θL − C (qL ) + (1 − α) [θL − θH ] = 0
  81. 81. Firm’s objective The firm’s objective is max α(pL − C(qL )) + (1 − α)(pH − C(qH )). qL ,pL ,qH ,pH Substituting in the material we just derived (Note: since ∗ qH = qH , we only need to worry about the choice of qL .): ∗ ∗ max α(θL qL −C(qL ))+(1−α) [θL qL + θH (qH − qL ) − C(qH )] . qL We can easily calculate the qL that maximises this by differentiating: α θL − C (qL ) + (1 − α) [θL − θH ] = 0 1−α Rearranging: C (qL ) = θL − α [θH − θL ]
  82. 82. Firm’s objective The firm’s objective is max α(pL − C(qL )) + (1 − α)(pH − C(qH )). qL ,pL ,qH ,pH Substituting in the material we just derived (Note: since ∗ qH = qH , we only need to worry about the choice of qL .): ∗ ∗ max α(θL qL −C(qL ))+(1−α) [θL qL + θH (qH − qL ) − C(qH )] . qL We can easily calculate the qL that maximises this by differentiating: α θL − C (qL ) + (1 − α) [θL − θH ] = 0 1−α Rearranging: C (qL ) = θL − α [θH − θL ] < θL
  83. 83. Discussion of the model The name of the game is to separate clients into groups and milk each group for as much as possible.
  84. 84. Discussion of the model The name of the game is to separate clients into groups and milk each group for as much as possible. The monopolist can squeeze more profit from high value customers, who will pay more for a given increase in quality.
  85. 85. Discussion of the model The name of the game is to separate clients into groups and milk each group for as much as possible. The monopolist can squeeze more profit from high value customers, who will pay more for a given increase in quality. But they can’t squeeze too hard—otherwise high value consumers will just buy the cheap product.
  86. 86. Discussion of the model The name of the game is to separate clients into groups and milk each group for as much as possible. The monopolist can squeeze more profit from high value customers, who will pay more for a given increase in quality. But they can’t squeeze too hard—otherwise high value consumers will just buy the cheap product. Solution: deliberately degrade the usefulness of the budget product to ensure that high-value customers refuse to buy it.
  87. 87. Discussion of the model The name of the game is to separate clients into groups and milk each group for as much as possible. The monopolist can squeeze more profit from high value customers, who will pay more for a given increase in quality. But they can’t squeeze too hard—otherwise high value consumers will just buy the cheap product. Solution: deliberately degrade the usefulness of the budget product to ensure that high-value customers refuse to buy it. Then the firm can charge a high price for the premium product, without worrying about customers switching to cheaper versions.
  88. 88. Discussion of the model The name of the game is to separate clients into groups and milk each group for as much as possible. The monopolist can squeeze more profit from high value customers, who will pay more for a given increase in quality. But they can’t squeeze too hard—otherwise high value consumers will just buy the cheap product. Solution: deliberately degrade the usefulness of the budget product to ensure that high-value customers refuse to buy it. Then the firm can charge a high price for the premium product, without worrying about customers switching to cheaper versions.
  89. 89. Examples £2/kg £2/kg £10/kg £18/kg
  90. 90. Examples It is not because of the few thousand francs which would have to be spent to put a roof over the third-class carriage or to upholster the third-class seats that some company or other has open carriages with wooden benches. . . What the company is trying to do is prevent the passengers who can pay the second-class fare from travelling third class; it hits the poor, not because it wants to hurt them, but to frighten the rich. . . (Ekelund [1970])
  91. 91. Note that the distortion of qL away from its optimal level is a market failure.
  92. 92. Note that the distortion of qL away from its optimal level is a market failure. However, it does not follow that the optimal policy is to prevent firms from second degree discrimination. . .
  93. 93. Second-degree discrimination & social welfare What will the firm do if it cannot price discriminate?
  94. 94. Second-degree discrimination & social welfare What will the firm do if it cannot price discriminate? ∗ ∗ ∗ ∗ Will provide either qH at price θH qH , or qL at price θL qL .
  95. 95. Second-degree discrimination & social welfare What will the firm do if it cannot price discriminate? ∗ ∗ ∗ ∗ Will provide either qH at price θH qH , or qL at price θL qL . In the efficient allocation, social welfare is ∗ ∗ ∗ ∗ α [θL qL − C(qL )] + (1 − α) [θH qH − C(qH )] . (we can ignore the ps which simply move surplus around).
  96. 96. Second-degree discrimination & social welfare What will the firm do if it cannot price discriminate? ∗ ∗ ∗ ∗ Will provide either qH at price θH qH , or qL at price θL qL . In the efficient allocation, social welfare is ∗ ∗ ∗ ∗ α [θL qL − C(qL )] + (1 − α) [θH qH − C(qH )] . (we can ignore the ps which simply move surplus around). In the second order price discrimination case, social welfare is ∗ ∗ α [θL qL − C(qL )] + (1 − α) [θH qH − C(qH )] .
  97. 97. Second-degree discrimination & social welfare What will the firm do if it cannot price discriminate? ∗ ∗ ∗ ∗ Will provide either qH at price θH qH , or qL at price θL qL . In the efficient allocation, social welfare is ∗ ∗ ∗ ∗ α [θL qL − C(qL )] + (1 − α) [θH qH − C(qH )] . (we can ignore the ps which simply move surplus around). In the second order price discrimination case, social welfare is ∗ ∗ α [θL qL − C(qL )] + (1 − α) [θH qH − C(qH )] . ∗ If the firm offers only qH , social welfare is ∗ ∗ (1 − α) [θH qH − C(qH )] . Thus social welfare falls.
  98. 98. Second-degree discrimination & social welfare What will the firm do if it cannot price discriminate? ∗ ∗ ∗ ∗ Will provide either qH at price θH qH , or qL at price θL qL . In the efficient allocation, social welfare is ∗ ∗ ∗ ∗ α [θL qL − C(qL )] + (1 − α) [θH qH − C(qH )] . (we can ignore the ps which simply move surplus around). In the second order price discrimination case, social welfare is ∗ ∗ α [θL qL − C(qL )] + (1 − α) [θH qH − C(qH )] . ∗ If the firm offers only qH , social welfare is ∗ ∗ (1 − α) [θH qH − C(qH )] . Thus social welfare falls. ∗ If the firm offers only qL , social welfare is ∗ ∗ ∗ ∗ α [θL qL − C(qL )] + (1 − α) [θH qL − C(qL )] , so that welfare may fall or increase relative to second-order PD.
  99. 99. More current examples In fact, when one thinks about it, there are similar-looking cases in many information markets:
  100. 100. More current examples
  101. 101. More current examples
  102. 102. More current examples
  103. 103. More current examples
  104. 104. More current examples
  105. 105. Outline Price discrimination: from assumptions to policy statements Assumptions and applicability
  106. 106. Assumptions, assumptions. . . But these examples are a little different to the ones considered before: Cost to MS of “surprising” a customer by giving them the professional, rather than home edition of Windows is basically zero.
  107. 107. Assumptions, assumptions. . . But these examples are a little different to the ones considered before: Cost to MS of “surprising” a customer by giving them the professional, rather than home edition of Windows is basically zero. Corresponds to C (q) = 0, C (q) = 0—which is contrary to our assumptions.
  108. 108. Assumptions, assumptions. . . But these examples are a little different to the ones considered before: Cost to MS of “surprising” a customer by giving them the professional, rather than home edition of Windows is basically zero. Corresponds to C (q) = 0, C (q) = 0—which is contrary to our assumptions. When we try to put this into the model things break down. Let’s see why. . .
  109. 109. Graphical treatment (assuming α = 1/2) Price Quantity Quality
  110. 110. Graphical treatment (assuming α = 1/2) Price θH Quantity Quality
  111. 111. Graphical treatment (assuming α = 1/2) Price Willingness to pay θH Quantity qH Quality
  112. 112. Graphical treatment (assuming α = 1/2) Price C’(q) Quantity Quality
  113. 113. Graphical treatment (assuming α = 1/2) Price C’(q) Cost of production Quantity qH Quality
  114. 114. Graphical treatment (assuming α = 1/2) Price C’(q) θH θL Quantity Quality
  115. 115. First degree discrimination Price C’(q) θH θL Quantity qL * qH * Quality
  116. 116. Graphical treatment Price CS of high types from buying C’(q) low quality good θH pL θ L= qL Quantity qL qH Quality
  117. 117. Graphical treatment Price CS of high types from buying C’(q) low quality good θH pL θ L= qL Quantity qL qH Quality
  118. 118. Graphical treatment Price C’(q) θH pH qH pL θ L= qL Quantity qL qH Quality
  119. 119. Graphical treatment Price CS of high types from buying C’(q) high quality good θH pH qH pL θ L= qL Quantity qL qH Quality
  120. 120. Graphical treatment Price C’(q) θH pL θ L= qL Quantity qL qL+Δ qH Quality
  121. 121. Graphical treatment Price Loss (must reduce pH to maintain ICH) C’(q) θH pL θ L= qL Quantity qL qL+Δ qH Quality
  122. 122. Graphical treatment Price Loss (must reduce pH to maintain ICH) C’(q) θH pL θ L= qL Gain (can charge more to low type consumers) Loss (higher q is more expensive to produce) Quantity qL qL+Δ qH Quality
  123. 123. Graphical treatment Price C’(q) θH pL θ L= qL Quantity qL qL * qH * Quality
  124. 124. Constant marginal cost Price θH pL θ L= qL C’(q) Quantity Quality
  125. 125. What goes wrong? Price θH pL θ L= qL C’(q) Quantity qL qL+Δ Quality
  126. 126. What goes wrong? (i) Price θH pL θ L= qL C’(q) Quantity qL qL+Δ qL qL+Δ Quality
  127. 127. What goes wrong? (ii) Price θH pL θ L= qL C’(q) Quantity qL qL+Δ qL qL+Δ Quality
  128. 128. Declining marginal willingness to pay. Price θH C’(q) θL Quantity Quality
  129. 129. Declining marginal willingness to pay. Price Declining ΔWTP θH Quantity Δq Δq Quality
  130. 130. First degree descrimination. Price θH C’(q) θL Quantity qL qH Quality
  131. 131. Profit effect of a quality increase. Price Loss (Need to lower pH to maintain ICH) θH Gain (Can charge more to low value consumers) C’(q) θL Quantity qL qL * qH * Quality
  132. 132. Other assumptions In a similar manner, one can relax other assumptions e.g.: Oligopoly suppliers. Many consumer types. Non-continuous q.
  133. 133. Summary Social science is about understanding society.
  134. 134. Summary Social science is about understanding society. That, at least in part, means trying to understand the fundamental forces that drive social phenomena.
  135. 135. Summary Social science is about understanding society. That, at least in part, means trying to understand the fundamental forces that drive social phenomena. Often, behaviour is fundamentally unchanged by new technology. Looking into the past can offer hints on how to understand and interpret the present.
  136. 136. Summary Social science is about understanding society. That, at least in part, means trying to understand the fundamental forces that drive social phenomena. Often, behaviour is fundamentally unchanged by new technology. Looking into the past can offer hints on how to understand and interpret the present. Moreover, the result of linking related phenomena is often an insight that exceeds the sum of its parts.
  137. 137. Summary Social science is about understanding society. That, at least in part, means trying to understand the fundamental forces that drive social phenomena. Often, behaviour is fundamentally unchanged by new technology. Looking into the past can offer hints on how to understand and interpret the present. Moreover, the result of linking related phenomena is often an insight that exceeds the sum of its parts. Sometimes the process works backwards: new contexts can generate insights into old puzzles—e.g. two-sided markets.
  138. 138. Summary Social science is about understanding society. That, at least in part, means trying to understand the fundamental forces that drive social phenomena. Often, behaviour is fundamentally unchanged by new technology. Looking into the past can offer hints on how to understand and interpret the present. Moreover, the result of linking related phenomena is often an insight that exceeds the sum of its parts. Sometimes the process works backwards: new contexts can generate insights into old puzzles—e.g. two-sided markets. A key ingredient in making these links is an understanding of the assumptions upon which alternative conceptualisations are predicated.
  139. 139. Summary Social science is about understanding society. That, at least in part, means trying to understand the fundamental forces that drive social phenomena. Often, behaviour is fundamentally unchanged by new technology. Looking into the past can offer hints on how to understand and interpret the present. Moreover, the result of linking related phenomena is often an insight that exceeds the sum of its parts. Sometimes the process works backwards: new contexts can generate insights into old puzzles—e.g. two-sided markets. A key ingredient in making these links is an understanding of the assumptions upon which alternative conceptualisations are predicated.

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